Breakdown of Covered Interest Parity: Mystery or Myth?

Abstract

The emergence and persistence of basis spreads in cross-currency basis swaps (CCBS) since the global financial crisis have become a mystery in international finance, as they violate the long-standing principle of covered interest parity (CIP). We argue that the phenomenon is no mystery but merely a reflection of the different risks involved between money market and CCBS transactions in the post-crisis era. Empirical results based on seven major currency pairs support our hypothesis that swap dealers behave as if they seek to align the risks of the transactions in pricing CCBS, which causes CIP to break down. We also find that the basis spreads are well arbitraged among the currency pairs, which suggests they are fairly priced. Hence, it is a myth that CCBS basis spreads or CIP deviations are evidence of the market not functioning properly.

Full Publication: The Price, Real and Financial Effects of Exchange Rates

Keywords: covered interest parity, FX swap, cross-currency basis swap, basis spread, CIP deviation, Libor-OIS spread, counterparty credit risk, funding liquidity risk

JEL Classification: F31, F32, G15